"Tying It All Together" with David Rosenberg
Our discussions (here, here, and here) of the dispersion of deleveraging efforts across developed nations, from the McKinsey report last week, raised a number of questions on the timeliness of the deflationary deleveraging process. David Rosenberg, of Gluskin Sheff, notes that the multi-decade debt boom will take years to mean revert and agrees with our views that we are still in the early stages of the global deleveraging cycle. He adds that while many believe last year's extreme volatility was an aberration, he wonders if in fact the opposite is true and that what we saw in 2009-2010 - a double in the S&P 500 from the low to nearby high - was the aberration and market's demands for more and more QE/easing becomes the volatility-inducing swings of dysphoric reality mixed with euphoric money printing salvation. In his words, perhaps the entire three years of angst turned to euphoria turned to angst (and back to euphoria in the first three weeks of 2012?) is the new normal. After all we had angst from 1929 to 1932 then ebullience from 1933 to 1936 and then back to despair in 1937-1938. Without the central banks of the world constantly teasing markets with more and more liquidity, the new baseline normal is dramatically lower than many believe and as such the former's impacts will need to be greater and greater to maintain the mirage of the old normal.
Meet The New Paradigm, Same As The Old Paradigm
Tying It All Together.
The people I speak to tell me that the extreme volatility and general market weakness last year was the aberration. The normal was the bounce we saw in 2009 and extension into 2010 — even though that extension was in dire need of a late-year round of QE2 intervention.
I'm actually wondering if it isn't the opposite. That last year was normal and what we saw in 2009 and 2010 — a double in the S&P 500 from the low to the nearby high —was the aberration.
Or maybe, just maybe, the entire three years of angst turned to euphoria turned back to angst (and back to euphoria in the first three weeks of 2012?) is the new normal. After all, we had market angst from 1929 to 1932 then ebullience from 1933 to 1936 and back to despair in 1937-38.
If there is one thing to take away from the McKinsey report, it is that we are into a completely different set of post-recession realities than what we were accustomed to through the post-WWII era. The prior 10 recessions before the epic 2007-09 downturn were nothing more than brief and small corrections in real GDP in the context of what was a generational secular credit expansion — an expansion that went asymptotic from 2002 to 2007. But make no mistake — this was a multi-decade debt boom and will take years to mean revert. As the McKinsey report concluded, we are still in the early stages of the global deleveraging cycle, and once it starts in the government sector, absent a notable upturn in private sector spending, recession risks will remain acute, if not a reality.
This is the lens from which we have to assess the economic base-case scenario, understanding that the range of outcomes are extremely wide, but the probabilities still skewed more towards the downside. What is to be considered "normal" should not be through the prism of the post-WWII period, when the secular credit expansion ensured that recessions were short and shallow and expansions long and strong—to the extent that central banks started to believe their own press that they had managed to defeat the business cycle and with that in mind, coined their own term of success: "The Great Moderation".
Today's "normal" is seen through the prism of the McKinsey report — what life looks like after a post-credit bubble collapse. And so far, what we have seen in the markets and the macro economic data—an initial sharp bounce, then a stalling out, wide fluctuations, ultra-low policy rates and bond yields, endless signs of economic fragility and recurring double-dip risk — is indeed quite normal in this context.
This by no means suggests that investment themes have vanished and that you can't make money and preserve capital in this sort of environment. There were plenty of ways to generate returns in 2011 —they just didn't really exist that much within the equity market universe. But let's go through where to prudently put money to work in the current and prospective backdrop, since we have to face up to the reality that you will not build up wealth or savings in T-bills, bank deposits or money market funds at today's near-zero percent interest rate environment:
1. Market volatility is part and parcel of every post-bubble deleveraging cycle. This means an ongoing focus on long-short relative value strategies that have little directional exposure with the overall market but take advantage of the inherent mispricing across sectors during these periods of heightened volatility.
2. Deflation trumps inflation as the primary trend in a deleveraging cycle. This means an emphasis on defensive sectors with earnings stability and predictability characteristics. It also means a focus on squeezing as much income as possible out of the portfolio. This is why "income equity" strategies make so much sense.
3. Balance sheet quality becomes so much more important in cycles like these. Already, we have seen the amount of AAA-rated government paper plunge 70% in the past three years from $19 trillion to $6 trillion. As such, emphasis on good quality corporate bonds in noncyclical sectors, attractive spreads, high net free cash flow yields, low debt ratios, high liquidity ratios and light refinancing calendars make prudent sense. Our good friend and top-ranked credit analyst Marty Fridson told me yesterday that even in the high-yield space, spreads off of government bonds have more than 100 basis points of tightening potential based on the current set of fundamentals.
4. Always be on the lookout for assets priced for recession. Not only are wide swaths of the credit market priced for such, but so are parts of the commodity complex and segments of the ex-North American equity market where P/E ratios are in single-digits and PEG (P/E to growth) ratios below unity.
5. In this post-bubble environment, policy rates will remain near the floor for years. As such, the risks of any sustainable bear market in bonds are very low since the cost of carry is so vitally important to the fixed-income markets, especially for longer duration product (keeping in mind that yield curves are still steep by historical standards).
6. Keeping policy rates low means that real rates will remain negative. Even if the CPI turns negative, the central banks around the world will de facto ease policy by printing money. In this sense, the secular bull market in gold bullion remains intact and, as such, dips should be bought (especially dips below the moving averages).
7. Global deleveraging cycles almost invariably bring on heightened geo-political tensions. This is why the oil price has such a high floor established underneath it. Protectionism will continue to emerge as a new normal, as part of the globalization trend gets reversed. Exposure to crude oil and materials makes good sense from a strategic point of view.
8. Populist policies win the roost in these types of cycles. The 99% extract their pound of flesh from the 1%. Conservatives like Newt end up sounding like Krugman when debating the likes of Romney. Luxury retailing, or any other fashion that benefits from the spending trend of the upper class, is probably a good shorting opportunity.